Millions Remain Vulnerable to the AMT

Floodgates of joy opened for millions of taxpayers when Congress passed the American Taxpayer Relief Act of 2012 in January—and potentially kept them from paying the alternative minimum tax.

Some 34 million Americans could have ended up in the grasp of the hated AMT last year if the tax laws had been allowed to revert to 2001 rules and the AMT had not been indexed permanently to inflation.

But as ecstatic as many are in escaping the AMT, an estimated 4 million taxpayers and counting will have to pay it for last year and in the future. And they could pay a higher AMT bill in the end.

"It's the typical middle-class person in high-income tax states and states that have expensive real estate taxes who will end up paying the AMT," said Stanley Veliotis, an assistant professor of accounting and taxation at Fordham University.

"Those states include California, Hawaii, Connecticut and New Jersey. Under AMT rules, people can't deduct state and local taxes and other deductions, and that will put them into the AMT," Veliotis said.

Most vulnerable are taxpayers with children—tax dependents—and who take home equity loan deductions, have capital gains, and have high state and local taxes. Those items are not deductible when calculating the AMT and usually put people at risk of having an AMT bill. Home mortgage interest payments are deductible under the AMT up to $1 million.

Established in 1969 to make sure higher-income earners paid their fair share, the AMT is essentially a parallel tax.

That means those in AMT brackets have to figure out which is more—the AMT or regular tax—and then pay the higher amount. The idea behind it was to prevent people with very high incomes from using special benefits to pay little or no tax.

But the AMT expanded over its 42-year history to apply to taxpayers who don't have very high incomes or don't claim lots of benefits.

Under the tax relief bill, exemptions from AMT are increased to $51,900 for individuals (up from $45,000) and $80,800 for married couples (up from $75,000) filing jointly in 2012. And exemptions are tied to inflation. That means as inflation climbs, the exemptions used to avoid the AMT will rise accordingly, which will reduce the number of people having to pay the AMT.

The current tax rate for the AMT is 28 percent. But Veliotis said that rate is deceptive for some who try to avoid it. "It's really closer to 35 percent for the AMT when everything is figured in," he said. "It's like a stealth tax, and it depends on adjusted gross income."

Higher income puts a taxpayer in the 35 percent bracket, according to Veliotis. If a worker gets a bonus, for example, adjusted income rises, but deductions are reduced accordingly.

"Many people are advised to pull in more income during a tax year and push off deductions to the next year to avoid the AMT in the year ahead," Veliotis said. "But that just really reduces the amount of deductions, like medical, and that, along with a bonus, in essence increases their income," he added. "It just means a higher AMT tax bill."

One part of the tax relief law won't help high-income earners avoid the AMT. To help pay for Obamacare, a new 3.8 percent tax on investment income—for incomes of $200,000 for single filers and $250,000 for couples—must be omitted when calculating if the AMT.

Including that new tax when determining regular tax liability against a potential AMT bill would probably keep many high-income earners from having to pay the AMT.

And even though the AMT is now indexed permanently to inflation, many will likely have to pay it as their income rise.

The Tax Policy Center estimates that the number of taxpayers who could pay the AMT because of income increases will jump 34 percent by 2018.

"It would be best to make things simpler and less complicated," said Mark Luscombe, the principal federal tax analyst at CCH. "The original purpose of the AMT was to make sure higher-income levels were paying their taxes. It's not doing that. But I don't think it's going away anytime soon."